Please Address To The Discussion Points Stated Below. Write Up To ...
Please address to the discussion points stated below. Write up to two hand-written or typed
pages. You are welcomed to add more of your opinions on the paper.
“CDOs-Squared Demystified”, Nomura Fixed Income Research
The paper makes the following claims on the impact of subordination, tranche size,
overlaps, correlation, default risk and recovery rate on the loss distribution of the CDO-
squared tranches.
1. Loss distribution of CDO-squared changes more dramatically as the amount of
subordination changes at the underlying CDO level.
2. The thinner tranche size of the underlying CDO tranches causes the expected losses and
the likelihood of a tranche wipeout of the CDO-squared to increase significantly.
3. Overlaps in the underlying CDOs cause the loss distribution to become “fatter-tailed”.
4. CDO-squared is more sensitive to changing correlation than are the underlying CDO
tranches.
5. The higher default rate causes the likelihood of higher losses to increase, but the loss
distribution changes only modestly.
6. CDO-squared tranche is much more sensitive to the recovery rate than the underlying
CDO tranches.
While the Nomura paper states the above pricing behaviors based on empirical studies,
the financial interpretations are not quite sufficiently deep. The following paper
“CDO2, correlation, overlap, and subordination: Implication for pricing and risk
management,” Benoit Metayer, Journal of Structured Finance, Winter 2006, p.59-70.
presents a more in-depth analysis of the impact of correlation, overlap, subordination, etc
on the loss distribution of tranches of CDO-squared. With the help of some the technical
analysis tools in Metayer (2006), you are asked to present stronger and convincing
arguments to the above 6 points on pricing behaviors stated in Nomura’s paper.
Other useful reference
1. “Drill-down approach for synthetic CDO squared transactions,” Standard & Poors, Dec
2003.
* All the papers can be downloaded from my web page.
